Strategic cost analysis in supply chain management

By Charles Nyika | Aug. 23, 2024

Supply chain practitioners should do cost analysis together with user departments with a view to eliminating unnecessary packaging.

TRADIYIONALLY, supply chain practitioners were known to rely on hard-nosed negotiations with the supply chain community with a view to reduce costs.

The trend has always been to save the company as much money as possible by pushing suppliers to the wall. The approach is slowly changing having realised that there is now a need for a serious paradigm shift.

It is now a competitive imperative for supply chain practitioners to begin searching above the low-hanging fruit and use more innovative methods of locating cost reductions than concentrating on exploiting the poor supplier.

There is need to cast their gaze elsewhere in search of sustainable savings. They need to think outside the proverbial box.

As a result, more and more procurement practitioners are now resorting to the concept of cost analysis to make economic and sustainable procurement decisions.

Cost analysis has been widely touted as the best way of creating more value and increasing quality service provisioning as well as reducing the organisation’s cost of sales.

Driven by the bottom-line and competitive pressures to serve customers, there is need for procurement professionals to understand what “cost analysis can do, does do and should do”.

The inherent appeal is its driving force to improve the bottom-line.

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As part of cost analysis, procurement practitioners should request the supplier to provide process charts covering the supplier’s activities from product enquiry to shipping of the product.

Such a process flow will provide the buyer with a precise picture of how the product is manufactured and how it then moves through the supplier’s supply chain.

The critical analysis of the supply chain activities by procurement personnel will reveal in some cases process delays, repetition of work processes, redundancies and or unnecessary waste.

Conventional wisdom will tell us that such kind of non-value added activities require immediate elimination with its associated costs.

It bears noting that activity-based costing, therefore, provides a picture of costs that are more accurately reflective of the costs associated with a particular product.

The most common cost analysis technique utilised by procurement personnel is the product breakdown or product teardown approach which basically entails the complete breakdown of product components in order to have a clear picture of how the product was manufactured.

An analysis of the component parts can assist the business in understanding the cost components that are used by suppliers in the manufacturing process.

This will assist procurement personnel to do their own independent calculations and then try to reconcile the calculations with the supplier’s pricing model.

By tearing the supplier’s product, the procurement department can easily provide their feedback to the supplier by providing progressive suggestions where certain component parts can be sourced elsewhere or where cheaper alternatives could be available.

Cost analysis also entails to a large extent understanding your supplier’s business and helping in the improvement of supply chain processes.

This may entail procurement practitioners going to the extent of interrogating and understanding how the supplier sources its raw materials and at what cost.

It may also be important to understand how suppliers arrange their logistics and at what costs.

It may be important to benchmark what technologies or manufacturing methods your suppliers are using against those of industry leaders.

Such processes can be sources of fat mark ups by the supplier or can be a source of avoidable inefficiencies.

Apart from cost analysis on specific product categories, supply chain industry experts also advocate that there is need to take a step further and request for a break-down of overhead data which is relevant to specific products in order to understand the whole cost structure.

Chances are, in certain instances, the overhead allocation of a certain cost to an item could potentially be subsidising another product which the organisation sells but may not be part of the buyer’s supply chain requirements.

There is often a tendency by suppliers to subsidise the costs of a loss-making product with the profits of a high profit-making product at the expense of buying organisations.

Such a detailed analysis of costs will be useful in the identification of cost drivers that are specific to the product that a buying organisation could be interested in.

It must also be noted that the costs that are normally incurred by suppliers are to a large extent influenced by the buying organisation’s activities.

User departments and procurement practitioners must know that parameters, such as product specifications will obviously have a significant impact on the final cost of producing a certain product or on the supply of a certain product.

User departments must avoid “gold plating” of specifications for their requirements just for the sake of it.

It is common knowledge that the more sophisticated the design for any product the more cost and time it takes to produce.

It is imperative for procurement practitioners to review and re-review such processes and activities and only process those requisitions with specifications that add value to the business.

In some instances, by doing such a detailed process and cost analysis through specifications review, procurement will discover fat pockets of savings.

Gold plating of specifications is often done by technical people who are in some cases never worried about costs.

Procurement should also advise user departments that other variables such as special packaging requirements and special design changes will have a significant bearing on the final cost of the product.

Supply chain practitioners should do cost analysis together with user departments with a view to eliminating unnecessary packaging requirements that have a negative effect on costs. Savings could easily be made where the user department, the procurement department and the supplier sit around the table to do a process map for the ordering of goods and or services.

More often than not such corporate conversations will identify cost variables that are not necessary but may come at a significant cost to the organisation.

Supply chain practitioners can also rely on industry cost analysis to uncover further savings within the supply chain. In this regard, the Procurement departments will be required to analyze and determine the cost structures obtaining in a certain industry and try to compare same to the organization’s specific situations.

In that vein, the buying organisations should expect a company with the latest technology to have lower labour rates and higher capacity utilisation.

Such kind of industry analysis can give the procurement department direction as to which companies to include on their supplier’s preferred list.

Suppliers which rely on antiquated technologies should be avoided as much as possible.

In most instances when a company introduces a new product or technology for the first time it is almost obvious that the cost structure will be on the higher side because initial cost structures are always based on preliminary cost indications.

It is also a fact that over time and due to the experience curve effects certain costs, relating to the production of a product will significantly go down with time.

Supply chain practitioners are, therefore, expected to continuously carry out a cost analysis with a view to ensuring that the organisation does not unknowingly continue to pay for excess labour hours and or excess waste that are a result of lack of experience on the part of the supplier’s production chain.

This can only be achieved where a proper cost analysis framework is put in place to review production processes over product life cycles of your procurement requirements.

Procurement personnel can also utilise the total cost of ownership model which basically critically analyses all the costs associated with the useful life span of a particular product.

It is often said that the product’s price and the acquisition costs associated in bringing a product into the organisation accounts for only 25-40% of the total lifecycle costs of the product.

The procurement strategy of using the total cost analysis model will, therefore, assess whether the cost of the product itself is within industry benchmarks.

The model will analyse to see whether the products are being shipped in the most cost-effective manner.

This model will also analyze the useful lifespan of the product together with issues relating to back-up service, disposal costs and ultimately salvage value at the time of disposal.

This model also analyzes whether certain internal procurement costs are really necessary and how the department can reduce its own purchasing cycle costs and time.

The cost analysis model is the way to go especially where competition does not exist, or where there is imperfect competition.

The question we may profitably ask is whether supply chain practitioners are leaving a lot of money on the table by not using the strategic cost analysis concept.

The question is often one of extent of use given that cost analysis is an area where big ticket savings are possible. It is a concept that is fast becoming synonymous with promise and potential.

The cost analysis concept will therefore continue to hold its special place in supply chain corporate conversations.